Transfer pricing is the rate at which two related parties in the same group carry out transactions with each other, which is determined by a myriad of factors, including what an arms-length price
for a similar transaction would be.
This principle, known as the arms-length standard (ALS), requires firms to set transfer prices according to their hypothetical equivalent arms-length price, and empowers taxing authorities to reset prices, reallocating income and deductions accordingly.
It is clear even from this cursory overview of transfer pricing rules that there are highly subjective judgments required at each stage of determining the arms-length price for an intra-firm transaction.
Given the considerable complexity and subjective judgments required to determine a hypothetical arms-length price for an intra-company transfer, what are the justifications for preserving this regime?
However, the transfer price bears no rational relation to any real distinction, and a transfer price set to a hypothetical arms-length price may only incidentally and partially reflect the respective contributions of related entities to the collective productive activity.
(54) The assumption that arms-length prices reflect economic reality of intra-firm transactions, though not made fully explicit in the Guidelines, is the first and most significant justification for the ALS regime.
In their paper, which was awarded the Chazen International Research Prize by Columbia's Graduate School of Business, Reichelstein and his co-authors demonstrate that the optimal internal transfer price for management purposes should be a weighted average of the producing division's pretax incremental cost and the most favorable arms-length price
admissible for tax reporting purposes.
In other words, the quest for an arms-length price
for transactions within a multinational group is a quest for something that does not generally exist.
Taxpayers do not purposefully set miles prices at a level higher than the arms-length price
, or their cost of goods at a level below that price.
It would seem that the most appropriate method to use in determining the arms-length price
would be the comparable uncontrolled price, resale price or comparable profit method using distribution comparables.
Firms that conduct many cross-border transactions with uncertain arms-length prices
, as with intellectual property, are apt to find advanced pricing agreements worthwhile.